Investors always want higher dividends, but do they consider the implications of rising dividends? Hence, let's look at the signs of a bad dividend. Then, you'll be able to spot future threats.
Should Have Seen This Coming
The coal company Walter Energy (WLT) has had a rough year, losing 70% of its valuation. A combination of lower demand for coal, liquidity issues, and uncertainty has led to its stock decline, but also significant revenue and margin declines.
Despite macro and operational concerns, Walter Energy had boosted its quarterly dividend from $0.05 to $0.13 from 2008 to 2013. The company's trailing annual yield is 4.6%, which is nearly insane, considering the company has an operating margin of (4.1%). Hence, the company isn't even profitable, but pays out more than $30 million in annual dividends.
Clearly, Walter Energy could not support its dividend, yet I suppose the company was crossing its fingers and awaiting macro improvements. On July 23, the inevitable finally occurred, as Walter cut its quarterly dividend by 92% to just $0.01. Now, Walter pays a forward yield of just 0.28%.
Walter Energy responded to the dividend news with stock losses over 15%. For some reason, investors expected the company to maintain its yield.
Indication of Dividend Troubles
For dividend investors, there are several measures you can take to ensure that your company is financially secure enough to maintain its dividend payout. First off, if a company is unprofitable, it is a good indication that dividends will be cut, as the concept of a dividend is to "share profit" with shareholders. Secondly, if a company is profitable you can assess its payout ratio, which tells how much of the company's profit is pays in dividends. Let me explain:
Washington Banking Company is clearly a bank, obviously located in Washington. Last Thursday, it slashed its quarterly dividend by 40%. This took the small cap company's dividend from almost 4% to 2.3%. Much like Walter, Washington Bank has a recent history of aggressive dividend hikes. Since 2009 the company has boosted its dividend from $0.03 to $0.15, a rate that it could not fundamentally support.
Washington Bank is by no means a growth company, but does operate with incredible efficiency, having operating margins of 38.5%. The problem is the company pays nearly 50% of its earnings on dividend payouts. This payout simply cannot be maintained for a company that has any aspirations of growth. It leaves very little money to reinvest back into the company; it keeps a company from accumulating cash; and it leaves a company vulnerable to any unexpected events.
Newmont Mining faced many of the same payout challenges as Washington Bank, but operates in a very unstable mining business much like Walter. Newmont was paying a dividend yield of 5%, had increased four-fold since the recession, and also had a payout ratio near 50%. In addition, Newmont also operates very efficiently with operating margins near 30%, but has seen a trend of margins declining faster than revenue. This perfect storm all combined to equal a near 29% cut in the company's dividend.
Big Name Dividend Concerns
Investors who follow Walter, Washington Bank, or Newmont could have all seen the dividend cuts coming. However, in a bullish market, there are a lot of companies that are boosting dividends in search of higher valuations. These actions are concerning with many of the market's best companies, such as Kellogg (K) and Hershey (HSY).
Last week, Kellogg increased its dividend 4.54% and Hershey increased its by 15.5%; these companies are now paying a yield of 2.76% and 2.09% respectively. The problem is that Hershey has a payout ratio of 52% and Kellogg an even worse 69%. To put this in perspective, Apple's payout ratio is 19%.
When assessing a payout ratio, a lot of factors come into play, such as the expense of the stock, cash on the balance sheet, and the industry of the company. Hershey and Kellogg are both non-cyclical, but ratios at this level leave little room for company investments, acquisitions, or to expand dividends further.
To me, Kellogg is the bigger problem. Clearly, its payout is higher, but its margins are also falling. Thus, lower margins equal lower profits and a more difficult payout. On the other hand, Hershey's margins are growing faster than its revenue, meaning it can handle a 15.5% dividend hike. However, with operating margins of 18.5%, I do wonder how much upside exists for Hershey, and if its 31 times earnings valuation can be maintained. While the company is clicking on all cylinders right now, investors need to take note of the vulnerabilities that could be presented if margins decline.
I mentioned Apple for a reason; its 19% payout ratio is healthy. Personally, I like to see companies with a payout ratio below 30%: Like an Exxon (XOM), AbbVie (ABBV), Anheuser-Busch (BUD), or Goldman Sachs (GS). These are high-yield stocks that can meet their dividend requirements regardless of short-term struggles. For companies like Kellogg, Hershey, BlackRock (BBK), or AT&T (T), these payouts can become problematic. Therefore, keep this in mind when seeking dividend investments, and be sure to always check the payout ratio.